3 Stocks for the Commercial Real Estate Recovery

3 Stocks for the Commercial Real Estate Recovery

If you're as confident as I am in the reported commercial real estate, or CRE, recovery, then I think your best option is to diversify within the market. I've selected a research firm, a real estate investment trust, and a brokerage to take advantage of this recovery. Each firm is best-in-class for its segment, and I think all three are great investments.

CoStar Group is in the most appealing defensive position, as it has a virtual monopoly in the research segment, and the expenditures necessary to enter this market serve as high barriers to entry. Extra Space Storage has an excellent growth story, and a strong future fueled by comp growth and acquisitions. CBRE Group is the best of the brokerages, and can leverage a diversified business platform and market-share growth to drive profits.

The research powerhouse
CoStar Group enjoys a wide moat as the largest CRE information provider in the United States. With the purchase of LoopNet completed last year, only Xceligent (which is owned by DMG Information, a subsidiary of British firm Daily Mail and General Trust) can be classified as a potential competitor. CoStar has a much broader reach, however (Xceligent doesn't even have a presence on most of the eastern seaboard). Because of the required investments in staff, infrastructure, and relationships, it will be difficult for another company to move into position to compete.

As CoStar continues to consolidate after the LoopNet merger, management has excellent opportunities to cross-sell CoStar products to LoopNet subscribers (and vice versa). As a result, I see continued sales growth ahead, even without further marketing and product development. Management predicts sales growth in the mid to high teens for the next year. Growth was already accelerating in the second quarter of 2013, with revenue up 28% year over year, and EPS improving from -$0.25 to $0.29.

There are some issues with CoStar Group, however. Earnings have been pretty uneven, with yearly EPS in 2010 of $0.64 dropping to $0.37 in 2012 (mostly because of LoopNet acquisition-related expenses), and the forward price-to-earnings ratio is a jaw-dropping 65, according to Morningstar. There is a lot of expectation baked into that number, and any disappointment on earnings will hurt. Also, if Xceligent (or another company) steps up competition in a major way, all bets are off. Such a rich valuation is appropriate only when given a growing, wide-moated company, not one locked in battle with a major competitor.

The innovator
Generally, I'm not a fan of industrial REITs. I believe that the sector is in a long-term decline for a variety of reasons, most notably because U.S. manufacturing is in the same decline. The one exception is in the self-storage business, which is booming. People have too much stuff, and they need a place to put it. According to Extra Space Storage's CEO Spencer Kirk:

[T]he country is growing at about 1% a year, about 3 million people. You would need to have on order of 500 to 550 new self-storage properties per year coming into the market to just keep pace with what the population is doing.

That increasing demand is fueling great growth for the self-storage sector. As the best-in-class of the fast-growing self-storage REITs, Extra Space Storage is an excellent place to park your investing dollars.

Last quarter was another blockbuster, with funds from operations -- a closer-to-cash measurement of REIT earnings -- of $0.50, and revenue of $126 million. Those results represented growth of 32% and 33%, respectively, from the same quarter last year. Even more telling, when we factor out acquisitions and look just at same-store sales, revenue grew 7.8% (surpassing a 6.7% increase from last year's second quarter). Even with the 3%-4% increase in rental rates and a 12% decline in discounts for new customers, occupancy still rose to 90.8%.

Believing the model to be scalable, management has 37 additional self-storage facilities under contract to close sometime during the fourth quarter. Management anticipates cap rates in the 6% to 7% range, which suggests to me that these are stable, quality properties. The cap rate is simply the net operating income -- that is, income less operating expenses -- divided by the price for the property. A high cap rate suggests a higher rate of return on a property, but investors often settle for lower cap rates on higher-quality, more in-demand properties in good locations.

I'm pretty debt-averse, so the debt-to-equity ratio of 1.2 doesn't thrill me, but for a REIT, the ratio isn't out of the ordinary. The forward P/E of 32.4 seems like a fair valuation given the growth prospects, but for value investors, that may seem a little high. As a growth-oriented investor, I'm all in for Extra Space Storage -- especially with a dividend topping 3%.

The global brokerage
CBRE Group stands to benefit perhaps the most from a recovery in the CRE market. As prices and rental rates rebound, the fixed-percentage fees that CBRE brokers charge for transactions will represent more revenue, and help drive the bottom line. Trading at a comparatively cheap forward P/E of 13.6, this company is a great opportunity for a value-minded investor. Unlike CoStar -- which operates in the U.S., part of Canada, and the United Kingdom -- and Extra Space Storage, which is limited to the U.S., CBRE operates on a global platform. It's therefore exposed to emerging markets, which also will help drive growth over the long term.

For the second quarter of 2013, CBRE reported 9% revenue growth that was driven by 16% revenue growth in the Asia-Pacific Region. Revenue grew 10% in the United States. Across the service lines, appraisal and evaluation revenue grew 10%, global properties sales revenue grew a whopping 20%, global corporate services (GCS) revenue grew 11%, and property, facilities, and project management revenue increased by 11%. Global investment management revenue decreased by 1%.

The relative decline in the importance of property leasing and sales, decreasing from almost 75% of CBRE's business in 2006, to 48% today, indicates increased diversification that will help the company continue to strengthen its market position. Speaking of market position, CBRE claims a 16.9% market share in the U.S., an increase of 1.1 percentage points from last year. Real Capital Analytics has ranked it as the No. 1 U.S. investment firm for the past seven years. This is the horse to bet on in brokerage.

Management has committed to reducing debt, and it made good on that promise in the second quarter by paying down $450 million of debt with an interest rate of 11.6%. Clearing that debt reduced CBRE's interest expense by 15%. Costs associated with clearing that debt reduced EPS by $0.08, resulting in a decline from $0.23 in the second quarter of 2012, to $0.21 in Q2 2013. But don't let those numbers fool you; this was a smart move by a company that had the money to dramatically improve its balance sheet.

Foolish conclusion
Investors, brokerages, and REITs need research and analytics regardless of the macro-environment, so CoStar Group is inherently dependable. Extra Space Storage has been in a steady price run-up since 2009, even while the CRE market has been sluggish, so the company may benefit even more from a rebound. CBRE will benefit directly and substantially from an improvement in the macro-environment, particularly as its revenue growth was pared down by market caution in Europe and, to some extent, in the United States. If you're bullish on CRE, these are stocks that should definitely be on your radar.

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The article 3 Stocks for the Commercial Real Estate Recovery originally appeared on Fool.com.

Michael Douglass has no position in any stocks mentioned. The Motley Fool recommends CoStar Group. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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